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Founders Share Classes

Early Investments and Lower Fees Boost Hedge Fund Return Potential

Background
Over the past 12 months, a substantial percentage of the capital invested in hedge funds has been allocated to funds with
over $1 billion in assets under management (AUM). According to HFR,1 during 2010, over 90% of net asset flows were
allocated to firms managing more than $1 billion. More specifically, funds managing over $5 billion (mega funds) garnered
the lions share of asset flows. As of December 2010, funds with AUM greater than $1 billion represented only about 16%
of the total number of hedge funds, yet they controlled over 87% of total industry assets. As recently as Q4 2009, net
asset flows had been much more evenly split between mega funds and smaller funds, with hedge funds managing less than
$1billion attracting approximately 47% of net asset flows.2
According to a recent article published by Callan Associates,3 several factors have led investors to favor mega funds: 1) in
the aftermath of the 2008 financial crisis and the Madoff fraud, investors placed a higher priority on a firms resources and
infrastructure, an area where mega funds have a clear advantage; 2) mega funds have been able to effectively service large
institutional clients, especially those that migrated from fund-of-funds to direct hedge fund investing; 3) many consultants
whose business models focus on a limited universe of large brand name hedge funds have steered money into mega funds;
and 4) large fund-of-funds have been forced to allocate to mega funds in order to secure significant capacity.
The capital-raising environment for smaller early stage hedge funds (ESFs) has been challenging despite significant
academic evidence that smaller funds have outperformed their more established peers. In an effort to compete with mega
funds for capital, many ESFs have begun offering a founders share class. The premise of a founders share class is to
encourage investors to allocate assets early by creating a separate share class with more favorable terms. This share class is
available either for a limited time period (for example the funds first six months) or until the fund reaches a certain AUM
level. The manager may offer investors the same favorable terms on subsequent investments. If offered, the extended
benefit is generally limited to a certain amount based on the original investment size.4
There are advantages to ESFs that offer more favorable terms to investors who commit during the limited time frame:
1)itencourages investors to invest in the ESF at its most critical juncture; 2) it minimizes issues that could arise if the fund
offers different terms to different investors; and 3) it avoids the challenge of negotiating terms with multiple investors.
Many managers find it simpler to offer a single set of terms to all investors. For investors, the lower fees available through
a founders share class increase performance beyond any excess return that academic studies have shown is available
fromESFs.
In this paper, we attempt to quantify the performance benefits of ESF outperformance and the direct economic benefit of
founders share classes. The overall impact depends on three factors: 1) The ESF alpha relative to mega funds; 2) the average
fees on the founders share classes in a portfolio; and 3) the percentage of a portfolio allocated to founders share classes. We
briefly examine each factor and show the potential performance impact under various assumptions.

Past performance is not indicative of future results. Please refer to Important Disclosures at the end of this Paper.
800 Westchester Avenue, S-528, Rye Brook, New York 10573 | T: (914) 798-7600 | F: (914) 251-1200

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Founders Share Classes


Early Investments and Lower Fees Boost Hedge Fund Return Potential

Factor 1: ESF Performance


A number of independent research studies have shown that ESFs, particularly those in capacity-constrained strategies,
consistently outperform more established hedge funds, both on an absolute and a risk-adjusted basis:

Hedge Fund Research found that over the 10-year period between 1994 and 2004, funds with less than a three-year
track record outperformed older funds by over 5% annually, with nearly identical volatility. Outperformance was
most pronounced during a funds first two years.5
Similarly, a 2009 study by PerTrac Financial Solutions found that younger and smaller funds have outperformed
larger and older funds over the long term. Specifically, PerTrac shows funds with less than $100 million in AUM
outperformed funds with more than $500 million in AUM by 377 basis points annually between 1996 and 2008,
with similar volatility. During the same period, funds with less than a two-year track record outperformed funds
with over a four-year track record by 562 basis points annually with lower volatility.6
Another study, The Performance of Emerging Hedge Fund Managers by Rajesh K. Aggarwal and Philippe
Jorion, adjusted the raw performance data to mitigate survivorship and backfill biases. This study also concluded
that emerging managers generate abnormal (excess) performance of 2.3% during their first two years relative to
lateryears.7

Reasons Why ESFs May Outperform


There are several structural factors that drive ESF outperformance. ESFs tend to be more nimble because of a smaller asset
base. As a result, they are better positioned to capture alpha by investing in off-the-radar securities that are too small for
mega funds to consider. Due to their smaller size compared to mega funds, ESFs can more easily trade into and out of
positions without impacting prices. Because smaller cap securities are often less liquid, mega funds typically avoid them
in favor of larger cap securities. ESFs size advantage is critically important in strategies that are less liquid and capacity
constrained (i.e. long-short small- to mid-cap equity, credit strategies, convertible bond arbitrage, etc.).
In an article entitled Size Matters When Pigs Fly, Callan Associates concluded that certain strategies are inherently
capacity-constrained and an overextended asset base undermines performance in larger funds due to illiquidity, embedded
beta and other issues of size. 8 The ability of ESFs to quickly adjust exposures and adapt to changing market conditions
may also explain why ESFs have outperformed without demonstrating higher risk. Smaller, more nimble managers may be better
able to reduce risk in periods of market stress. They may also be more motivated to reduce risk given the significant role
drawdown avoidance plays in the future growth and viability of a managers business.
Economic incentives also drive ESF outperformance. Larger hedge funds earn substantial management fees regardless of
investment performance. Protecting that recurring fee stream is a strong incentive to adopt a conservative approach. Over
time, this philosophy can lead to mediocre returns that cluster around the mean. As money management firms grow, they
can become more interested in growth than in performance, and the distribution of their returns tends to converge toward
the mean.
A 2006 study by Northern Trust9 supported the idea that larger funds are more likely to cluster around the mean. Although
this study was focused on traditional mutual funds rather than hedge funds, the findings appear equally relevant to hedge
funds. Northern Trust analyzed performance of 531 active U.S. equity managers over a five-year period and found that
small firms outperformed the elephantine household names at the median, as well as at the top and bottom quartile levels.
In addition, the study found that in general, results for smaller firms are more dispersed, showing a broader range of
performance on both the upside and the downside.
Past performance is not indicative of future results. Please refer to Important Disclosures at the end of this Paper.
800 Westchester Avenue, S-528, Rye Brook, New York 10573 | T: (914) 798-7600 | F: (914) 251-1200

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Founders Share Classes


Early Investments and Lower Fees Boost Hedge Fund Return Potential

If the largest funds continue to attract the majority of new assets, the clustering around the mean trend for mega funds may
continue. By contrast, ESFs cannot survive on management fees alone. These funds must generate superior performance to
attract new investors and, in some cases, to cover salaries and expenses. In summary, various academic research has shown that
ESFs outperformed established funds in a range of 2%-5% per annum over the long term. We believe the structural factors
that have led ESFs to outperform in the past are likely to persist.

Potential Risks
While there is no evidence that ESFs have greater volatility of returns than mega funds, there is potential for heightened
business risk. As ESFs are smaller in size, they typically have fewer resources and a smaller operational infrastructure than
mega funds. Fewer people may be responsible for the wide range of functions outside portfolio management, which can
create distractions and increase business risk. Funds may close down if they are unable to attract sufficient capital to build a
profitable business and smaller funds are likely to have a more concentrated investor base, which presents continuity issues.
(It is important to note the dissolution of an ESF does not necessarily have negative performance consequences if the fund
maintains appropriate liquidity.) As outlined in the Northern Trust study the broader dispersion of small manager returns has
led them to be over-represented in both the top and bottom quartiles, highlighting the potential risks as well as the rewards of
investing with them. The results show that manager selection is vital when investing in ESFs. For these reasons, we believe
ESF investing requires significant experience and expertise. Investors who lack experience evaluating the business, operational
and investment risks faced by ESFs may decide that the cost of sourcing and conducting due diligence on these managers
outweighs the potential benefits.

Factor 2: Terms
Notwithstanding the occasional news article about a public pension plan demanding lower fees from its hedge fund managers10
or a firm cutting fees to retain investors,11 most mega funds still maintain the customary 2.0% management fee and 20%
incentive fee with no hurdle rate. In fact, a recent study by Absolute Return indicated that hedge funds managing over
$5billion increased their fees in 2010 with the average fund in this group charging a 2.04% management fee and a 22.28%
incentive fee.12 In March of 2009, in the midst of the financial crisis and while the hedge fund industry was still licking its
wounds, the Utah Retirement System (URS) published a paper proposing preferred terms that URS believed to be
appropriate for institutional investors in hedge funds.13 Many of the terms now being offered by ESFs via founders shares
are consistent with the proposed terms outlined in this paper, with the notable exception of claw back provisions on
incentive fees, which remain uncommon. We have found that, on average, the founder s share class management fee discount
is approximately 50 basis points and the average incentive fee discount is 5%. Though offering a hurdle rate is becoming more
common, this remains the exception rather than the rule. In general, founders share class investments offer the same liquidity
terms offered to other LPs, so these investments are not a case of trading liquidity for return. Rather, because it is difficult for
ESFs to attract capital, investors with expertise and resources to identify talented ESFs can benefit from reduced fees without
having to sacrifice manager quality, liquidity or performance.

Factor 3: Portfolio Composition


The final factor in determining the potential excess return available by participating in founders share classes is the percentage
of the portfolio allocated to such opportunities. If an investor is seeking proper diversification, the portfolio should have
exposure to a range of managers and strategies. For strategies that are complex (i.e. quantitative strategies like statistical equity

Past performance is not indicative of future results. Please refer to Important Disclosures at the end of this Paper.
800 Westchester Avenue, S-528, Rye Brook, New York 10573 | T: (914) 798-7600 | F: (914) 251-1200

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Founders Share Classes


Early Investments and Lower Fees Boost Hedge Fund Return Potential
arbitrage), mega funds bring the benefits of significant resources, including the ability to negotiate more favorable terms with
prime brokers and other counterparties. In strategies that are very liquid (i.e. Global Macro or CTA), ESFs do not have any
inherent advantage. By contrast, in capacity constrained strategies, ESFs are more likely to have a performance advantage.
Larch Lane believes a portfolio composed of both ESFs and established funds provides the best risk-adjusted long-term
performance. The ratio of ESFs to established funds will vary based on the desired strategy allocation, as well as managerspecific factors. For example, if a portfolio is more heavily weighted towards complex strategies, the percentage of ESFs is
likely to be lower. Also, an investor may not be able to identify outstanding ESFs in a particular strategy. Of course, not all
ESFs offer discounted fees and, by definition, those opportunities are only available for a limited time. Therefore, investors
should assume that the percentage of a portfolio allocated to founders share classes will vary significantly over time.

Potential Performance Impact


How much performance benefit can be achieved by allocating a portion of a hedge fund portfolio to founders share class
investments? To model the impact, we assume that founders share class investments have a 1.5% management fee and
15% incentive fee compared to the more standard 2.0% management fee and 20% incentive fee. Using these assumptions,
Figure1 shows how the expected net return differs for investors in a founders share class compared to a standard share
class investment under various annualized return assumptions. It also illustrates the return differential over a 5-year period
assuming a $10million initial investment.14
FIGURE 1:

Net Return Differential between Founders Share Class Investment and Standard Investment Terms
Assumptions
Established Funds

ESFs

Management fee
Incentive fee

2.0%

Management

1.5%

20.0%

Incentive fee

15.0%

Initial Investment Amount

$10,000,000

Returns are hypothetical only and do not represent actual returns on any fund or portfolio.

Fund Gross Return

Standard Share Class Return


Founders Share Class Return
Annual Differential

5-year excess return

0.0%

5.0%

10.0%

15.0%

20.0%

-2.0

2.4%

6.4%

10.4%

14.4%

-1.5%

3.0%

7.2%

11.5%

15.7%

0.5%

0.6%

0.8%

1.1%

1.3%

$232,957

$319,680

$536,939

$814,165

$1,161,315

Returns are hypothetical only and do not represent actual returns on any fund or portfolio.

Past performance is not indicative of future results. Please refer to Important Disclosures at the end of this Paper.
800 Westchester Avenue, S-528, Rye Brook, New York 10573 | T: (914) 798-7600 | F: (914) 251-1200

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Founders Share Classes


Early Investments and Lower Fees Boost Hedge Fund Return Potential
Figure 2 further illustrates the potential net return impact of an assumed 50% portfolio weighting in founders share
investments:
Figure 2:

Portfolio Impact of Founders Share Class Allocation


Founders Share Portfolio Impact 50% Allocation
14%
12%

Standard Net Return


Founders Share Additional Net Return

Net Return

10%
8%
6%
4%
2%
0%

7.5%

10.0%

12.5%

15.0%

Gross Return
Returns are hypothetical only and do not represent actual returns on any fund or portfolio.

Based upon the assumptions in our analysis


(forpurposes of our calculations, we
assume fees of 1.5% and 15% with no
hurdle rate or claw back provisions and
we assume that ESFs outperform mega
funds by 2% perannum), a 50% portfolio
allocation to founders shares enhances
net returns by 120 to 140 basis points per
annum. This is a meaningful difference in
the context of historical fund-of-hedge funds
performance. In a Brockhouse Coopers
analysis of fundofhedge fund returns over
the 10-year period from 2001-2010, only
1.2% separated top quartile performance
from bottom quartile performance.15 While
many institutions may be unwilling to allocate
50% of their portfolio to ESFs, even a more
modest allocation can have a meaningful
impact on overall performance.

Conclusion
In the current environment, it is challenging for most ESFs to attract capital. As a result, investors with the ability to identify
and invest in talented ESFs may obtain more favorable terms through a founders share class. Several research studies have
shown that ESFs have outperformed more established funds with similar risk. Therefore, investors who allocate a portion
of their portfolios to founders share investments can potentially achieve higher returns as a result of both lower fees and
higher expected returns. We estimate that if investors allocate 50% of their portfolios to founders share class investments,
net returns could increase by 1.2% - 1.4% per annum. Adding over 100 basis points to annual return expectations would
be very meaningful as the long-term differential between top and bottom quartile hedge fund portfolios is typically within
this range. Ultimately, the primary consideration when selecting a manager should always be the managers quality and the
attractiveness of the investment strategy. But once a fund meets an investors selection criteria, securing favorable fee terms
can have a significant impact on long-term performance. As a result, we believe that investors will broaden their focus to
include earlier and larger allocations to ESFs offering founders share classes.

Past performance is not indicative of future results. Please refer to Important Disclosures at the end of this Paper.
800 Westchester Avenue, S-528, Rye Brook, New York 10573 | T: (914) 798-7600 | F: (914) 251-1200

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Founders Share Classes


Early Investments and Lower Fees Boost Hedge Fund Return Potential

Important Disclosures:
General
This document is for informational purposes only and is not intended to be, and should not be construed as, an offer to sell, or the
solicitation of an offer to buy, any interest in any entity or other investment vehicle discussed herein. Any such offer or solicitation
will be made to qualified investors only by means of a final offering memorandum and only in those jurisdictions permitted by
law. If such an investment opportunity should become available, a confidential private offering memorandum outlining such
investment opportunity would be provided to you together with the governing documents of the relevant investment vehicle, and
the information in this discussion would be qualified in its entirety by reference to all of the information and terms, including the
risk factors, in such confidential private offering memorandum and governingdocuments.
This document is privileged and confidential and it is intended solely for the use of the person to whom it has been delivered (or
persons within the recipients organization) for the purpose of evaluating Larch Lanes business and is not to be reproduced or
distributed to any other persons (other than persons in the recipients organization) without the prior written consent of Larch
Lane. This document is not a complete summary of the terms of the investment management services offered by Larch Lane and
is qualified in its entirety by, and must be read in conjunction with, more detailed information regarding Larch Lane, including Part
2 of its Form ADV.
This document contains statements which constitute forward-looking statements. These statements may include statements
regarding the intent, belief or current expectations of Larch Lane with respect to, among other things: (i) the diversification of the
portfolio; (ii) the ability to identify investment opportunities; (iii) the performance of the portfolio managers or their affiliates; and
(iv) the state of the economy, the financial markets and the financial industry. Prospective investors are cautioned that any such
forward-looking statements are not guarantees of future performance and involve risks and uncertainties, and that actual results
may differ materially from those in the forward-looking statements as a result of variousfactors.
Any opinions expressed in this document may be subject to change without notice. Although statements of fact and data
contained in this document have been obtained from, and are based upon, sources that Larch Lane believes to be reliable, Larch
Lane does not guarantee their accuracy, and any such information may be incomplete or condensed. No representation is made that
the information contained herein is accurate or complete, and it may not be relied upon as such.

Endnotes
1
2
3
4

5
6

HFR Global Hedge Fund Industry Report, Year End 2010.


HFR Global Hedge Fund Industry Report, Q4 2009.
Callan Alternatives Institute, Hedge Fund Monitor, Third Quarter 2010.
A manager may offer a founders share class with reduced fees that is available
only until the funds AUM reaches $100 million, but the manager may continue
to honor the reduced fees on a pre-determined amount of future investments.
This amount will typically be limited to a multiple of the investors original
capital commitment. This prevents investors from locking in the founders
share terms by making a very small initial capital commitment and then
continuing to benefit from favorable terms on much larger subsequent
investments after the manager is more established and no longer needs to offer
reduced fees.
Emerging Manager Out-Performance: Alpha Opportunities from the
Industrys Newest Hedge Fund Managers. HFR Asset Management, 2005.
An Examination of Fund Age and Size and Its Impact on Hedge Fund
Performance, by Meredith Jones. PerTrac Financial Solutions. Data from
January 1996-December 2008.
 The Performance of Emerging Hedge Fund Managers, by Rajesh K.
Aggarwal and Philippe Jorion. American Finance Association Meeting Paper.
January 23, 2008, page 30.
Callan Alternatives Institute, Hedge Fund Monitor, Third Quarter 2010.

9 I nsights on Potential Benefits of Investing with Emerging Managers.


Northern Trust, 2006.
10 See e.g. N.J. lowers alts managers fees, Pensions & Investments, February
2011.
11 See e.g. Hedge fund D.E. Shaw cuts fees, Reuters, February 2011. Of
note: According to this article, after losing roughly half of its peak AUM
and generating a return of 2.5% in 2010, D.E. Shaw cut the fees in its
Composite Fund from a 3% management fee and 30% incentive fee to a 2.5%
management fee and 25% incentive fee.
12 Larger Hedge Funds Increase Fees in 2010, Absolute Return + Alpha,
March 2011.
13 Summary of Preferred Hedge Fund Terms, Utah Retirement Systems
Investment Group, March, 2009.
14 This example does not consider other fund expenses, which may be
substantially higher for hedge funds with limited AUM. Founders share class
investors may be able to negotiate caps on these expenses.
15 Performance Appraisal Report, B&C Fund of Hedge Funds Mandate Universe,
December 2010. Brockhouse & Cooper Inc. provides advisory services to
pension plans, foundations and endowments, financial institutions, family
offices and other institutional investors. The firm maintains an extensive
database of FoHF performance data, which is updated on a quarterly basis.

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